Uneasy Money

One of my favorite papers is one published by J. R. Hicks in 1935 “A Suggestion for Simplifying the Demand for Theory of Money.” The aim of that paper was to explain how to reconcile the concept of a demand for money into the theory of rational choice. Although Marshall had attempted to do so in his writings, his formulations of the idea were not fully satisfactory, and other Cambridge economists, notably Pigou, Lavington, Robertson, and Keynes, struggled to express the idea in a more satisfactory way than Marshall had done.

In Hicks’s introductory essay to volume II of his Collected Essays on Economic Theory in which his 1935 essay appears, Hicks recounts that Keynes told him after reading his essay that the essay was similar to the theory of liquidity preference, on which Keynes was then working.

To anyone who comes over from the theory of value to the theory of money, there are a number of things which are rather startling. Chief of these is the preoccupation of monetary theorists with a certain equation, which states that the price of goods multiplied by the quantity of goods equals the amount of money which is spent on them. The equation crops up again and again, and it has all sorts of ingenious little arithmetical tricks performed on it. Sometimes it comes out as MV = PT . . .

Now we, of the theory of value, are not unfamiliar with this equation, and there was a time when we used to attach as much importance to it as monetary theorists seem to do still. This was in the middle of the last century, when we used to talk about value being “a ratio between demand and supply.” Even now, we accept the equation, and work it, more or less implicitly, into our systems. But we are rather inclined to take it for granted, since it is rather tautologous, and since we have found that another equation, not alternative to the quantity equation, but complementary with it, is much more significant. This is the equation which states that the relative value of two commodities depends upon their relative marginal utility.

Now to an ingénue, who comes over to monetary theory, it is extremely trying to be deprived of this sheet-anchor. It was marginal utility that really made sense of the theory of value; and to come to a branch of economics which does without marginal utility altogether! No wonder there are such difficulties and such differences! What is wanted is a “marginal revolution!”

That is my suggestion. But I know that it will meet with apparently crushing objections. I shall be told that the suggestion has been tried out before. It was tried by Wicksell, and though it led to interesting results, it did not lead to a marginal utility theory of money. It was tried by Mises, and led to the conclusion that money is a ghost of gold – because, so it appeared, money as such has no marginal utility. The suggestion has a history, and its history is not encouraging.

This would be enough to frighten one off, were it not for two things. Both in the theory of value and in the theory of money there have been developments in the twenty of thirty years since Wicksell and Mises wrote. And these developments have considerably reduced the barriers that blocked their way.

In the theory of value, the work of Pareto, Wicksteed, and their successors, has broadened and deepened our whole conception of marginal utility. We now realize that the marginal utility analysis is nothing else than a general theory of choice, which is applicable whenever the choice is between alternatives that are capable of quantitative expression. Now money is obviously capable of quantitative expression, and therefore the objection that money has no marginal utility must be wrong. People do choose to have money rather than other things, and therefore, in the relevant sense, money must have a marginal utility.

But merely to call their marginal utility X, and then proceed to draw curves, would not be very helpful. Fortunately the developments in monetary theory to which I alluded come to our rescue.

Mr. Keynes’s Treatise, so far as I have been able to discover, contains at least three theories of money. One of them is the Savings and Investment theory, which . . . seems to me only a quantity theory much glorified. One of them is a Wicksellian natural rate theory. But the third is altogether more interesting. It emerges when Mr. Keynes begins to talk about the price-level of investment goods; when he shows that this price-level depends upon the relative preference of the investor – to hold bank-deposits or to hold securities. Here at last we have something which to a value theorist looks sensible and interesting! Here at last we have a choice at the margin! And Mr. Keynes goes on to put substance into our X, by his doctrine that the relative preference depends upon the “bearishness” or “bullishness” of the public, upon their relative desire for liquidity or profit.

My suggestion may, therefore, be reformulated. It seems to me that this third theory of Mr. Keynes really contains the most important of his theoretical contribution; that here, at last, we have something which, on the analogy (the approximate analogy) of value theory, does begin to offer a chance of making the whole thing easily intelligible; that it si form this point, not from velocity of circulation, or Saving and Investment, that we ought to start in constructing the theory of money. But in saying this I am being more Keynesian than Keynes [note to Blue Aurora this was written in 1934 and published in 1935].

The point of this extended quotation, in case it is not obvious to the reader, is that Hicks is here crediting Keynes in his Treatise on Money with a crucial conceptual advance in formulating a theory of the demand for money consistent with the marginalist theory of value. Hicks himself recognized that Keynes in the General Theory worked out a more comprehensive version of the theory than that which he presented in his essay, even though they were not entirely the same. So there was no excuse for Friedman to present a theory of the demand for money which he described “as part of capital or wealth theory, concerned with the composition of the balance sheet or portfolio of assets,” without crediting Keynes for that theory, just because he rejected the idea of absolute liquidity preference.

Here is how Hicks summed up the relationship in his introductory essay referred to above.

Keynes’s Liquidity theory was so near to mine, and was put over in so much more effective a way than I could hope to achieve, that it seemed pointless, at first, to emphasize differences. Sometimes, indeed, he put his in such a way that there was hardly any difference. But, as time went on, what came to be regarded in many quarters, as Keynesian theory was something much more mechanical than he had probably intended. It was certainly more mechanical than I had intended. So in the end I had ot go back to “Simplifying,” and to insist that its message was a Declaration of Independence, not only from the “free market” school from which I was expressly liberating myself, but also from what came to pass as Keynesian economics.